Individual retirement accounts are getting some competition as the retirement savings vehicle of choice. With total holdings surpassing $7.5 trillion in 2016, IRAs are still the go-to option for more than one-third of U.S. households, but health savings accounts are gaining ground. HSAs, which are associated with high deductible health insurance plans, grew 22 percent in 2016 to 20 million accounts totaling $37 billion in assets, according to HSA consulting firm Devenir. HSA investment assets reached $5.5 billion, a 29 percent increase year-over-year.
The tax-advantaged nature of HSAs, which are used primarily to reimburse an account holder’s out-of-pocket health care costs, is a significant part of their appeal. “HSAs are the holy grail of tax planning,” says Megan Gorman, managing partner at Chequers Financial Partners in San Francisco.
[See: 11 Ways President Trump’s Tax Plan Could Affect Americans.]
The tax benefits begin with an above-the-line deduction for contributions, reducing gross income. Those benefits continue with tax-deferred growth, allowing earnings to compound, and tax-free distributions for medical expenses. “It’s a tax bonanza,” Gorman says, adding that HSAs are a tax shelter that can benefit a significant number of taxpayers, not just the wealthy.
While HSAs are designed to help you save for future health care expenses, they also have potential as a retirement planning tool. The key is knowing how to make the most of them.
They double as retirement savings accounts. What many savers may not understand is that HSA distributions are not exclusive to health care. “HSA funds don’t have to be used to pay for medical expenses,” says Chad Wilkins, executive vice president of Webster Bank and head of HSA Bank in Sheboygan, Wisconsin.
Beginning at age 65, savers can withdraw HSA funds for any purpose without a tax penalty. For example, if you’re planning to delay taking Social Security benefits, you could use the money from your HSA to supplement withdrawals from a 401(k) or IRA in the meantime. There is, however, a catch. You’ll pay ordinary income tax on distributions that aren’t used for qualified medical expenses.
You can also take money out of an HSA before age 65 for purposes other than health care, but that can be costly, says Lou Cannataro, partner at New York-based Cannataro Park Avenue Financial. “Like every other tax-favored tool, there’s always a hook,” Cannataro says. The hook for taking early distributions for nonmedical purposes is a 20 percent tax penalty, in addition to regular income tax.
You can, however, carry over HSA contributions from year-to-year. “Unlike a flexible spending account, HSA money doesn’t need to be spent on medical expenses by the end of the year,” says Thomas Lowry, a financial advisor and president of Georgia Wealth Advisors in Atlanta. Lowry says savers can keep money in their HSA and invest it. Anything you don’t spend can “continue to accumulate much like a 401(k) or other investment account.”
They have an edge over IRAs. If you’re using an HSA to round out your retirement plan, you need a strategy for saving. Lowry suggests starting with a 401(k), and then funding an HSA.
[See: 10 Long-Term Investing Strategies That Work.]
“If you have all your money in a 401(k) and have a medical emergency, you may have to take a hardship loan to pay those medical bills,” Lowry says. “Having an HSA gives you access to cash for medical reasons so you don’t have to borrow money from your workplace retirement plan.”
Republican plans to revamp health care and expand HSA contribution limits could make the accounts even more attractive to savers. If the plan is approved, individual HSA contributions would increase to $6,550 from $3,400 in 2017, while the family contribution limit would rise to $13,100 from the current $6,750. Savers age 55 and older can contribute an additional $1,000 annually. Although it’s less than what a 401(k) allows annually, the maximum HSA contribution amount outstrips the current IRA contribution limit of $5,500.
Besides the potential for workers to save more, HSAs have a crucial edge over IRAs: There are no required minimum distributions from an HSA once you reach age 70½, says Mike Frost, senior wealth planning strategist at Wells Fargo Private Bank in McLean, Virginia. “Younger workers can start saving in an HSA now and keep that account well into their retirement years if they don’t spend the money,” Frost says.
You may want to consider having a buffer of liquid savings that you can use to cover minor out-of-pocket costs like co-pays. This way, you can avoid depleting your HSA savings, tapping them only for major medical expenses.
The same rules for investing still apply. When it comes to choosing how to invest your HSA funds, Wilkins says there are several things to keep in mind.
For example, you should look at the investment options the financial institution that manages your HSA offers. Depending on your plan, those options may include stocks, bonds, mutual funds or exchange-traded funds.
The investments you include in your HSA should reflect your current financial and health situation, as well as your overall risk tolerance. “If you have ample income or assets and plan to pay out-of-pocket medical expenses with current cash flow or other assets, then you can afford to be very aggressive,” Cannataro says. “If you have to access these funds in the short term if medical expenses arise, then you may want to build a more conservative portfolio.”
Your horizon until retirement also matters. As with any invested savings, Frost says, you’ll need to balance risk with growth, or “the account could lose significant value in a long market downturn” before you retire, leaving you with less money than you expected.
Fees are another consideration, as are health care costs. Gorman says that most Americans underestimate medical costs in retirement. She says most people think Medicare will be enough, but that’s not always true. For instance, Medicare doesn’t cover expenses associated with long-term care. In 2016, the average annual cost of a semi-private room in a nursing home topped $82,000, according to Genworth Financial.
Although HSA funds can be used to pay for pricey nursing home care, the challenge for many Americans is contributing the maximum annual amount.
[See: 11 Tips for the Sandwich Generation: Paying for College and Retirement.]
“The best way to lower medical costs in retirement is to take good care of yourself in your younger years,” Gorman says, but from a financial perspective, “you should consider saving as much as possible in your retirement plan to cover all costs.”
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